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The Secret To Understanding ARMs

By Melba M. Sheffer

In addition to all of the other decisions you have to make when you are choosing a mortgage, such as whether to go fixed or floating rate, how much down payment to make and how many points to pay, lenders have further complicated everything by offering a wide range of choice of indexes for ARMs (adjustable rate mortgages).

When we speak of the “index”, we are speaking of the base financial instrument that the adjusting rates will be based upon. These indices could be such instruments as the T-Bill rate, the rate of Federal Funds, or rates based on LIBOR.

You must initially understand that an ARM is a loan with an interest rate that moves up or down within a certain set period, and the movements are predicated upon the movements of the underlying index. If your index is CDs, and CDs go up, your interest rate increases. Adjustable rate mortgages have adjustment caps, which means that the interest rate can only be adjusted at given periods, even if the underlying interest rate goes up more frequently; this can be an advantage if you just readjusted and then rates move up. It can be a disadvantage if you have just readjusted, and afterwards there is a downward movement, however.

Your ARM may be tied to the Treasury Bill rate, which is the rate the United States Government pays on its 90 day investments. The Fed Fund rate is the rate banks pay to the Federal Reserve Bank to borrow money. Many of the international banks will use the LIBOR as the index rate for loans.

Deciding upon which index is best for you will depend on your own situation as well as your view of interest rate movements. If you prefer a rate that is responsive to the interest rate market, you should choose the CD rate as your index. Adjustable rate mortgages that use T Bills tend to change more slowly. LIBOR is the index that moves the most often and the most rapidly, so if you want to take frequent advantage of the downward level of decreasing rates, this is the one for you.

An option ARM is one where the interest rate adjusts monthly and the payment adjusts every year, and the borrower is offered an “option” on how large a payment he wants to make. The idea behind these loans is that they are basically interest only loans, so you have to pay that minimum, and then you can choose to pay more. One of the big issues with an option mortgage is that you can end up with an increasing instead of decreasing mortgage; this is also known as negative amortization.

This is a lot of information for the home buyer to digest, and the best solution is to consult with a professional mortgage broker who can explain it all and recommend the best course for you.

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Article Citation
MLA Style Citation:
Sheffer, Melba M. "The Secret To Understanding ARMs." The Secret To Understanding ARMs. 7 Jul. 2010. 29 Dec 2014 <>.

APA Style Citation:
Sheffer, M (2010, July 7). The Secret To Understanding ARMs. Retrieved December 29, 2014, from

Chicago Style Citation:
Sheffer, Melba M. "The Secret To Understanding ARMs"

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